Will inflation continue its upward trajectory?

UK Inflation reached 9.1% year-over-year in May (compared with 9.0% in April). This was primarily driven by price increases in energy, and food and non-alcoholic beverages. On a positive note, core inflation reduced for the first time since September to 5.9% from 6.2%, suggesting domestically generated cost pressure is reducing.
     
Significant uncertainty persists around the future path of inflation, but we expect it will peak at 10.3% in Q4 2022. Thereafter, inflation should start reducing as demand weakens, supply chains gradually normalise and commodity and oil price rises moderate and fall. The CBRE house view is that inflation will fall back to 1.5% by Q4 2023, which is consistent with annual average inflation of 8.7% in 2022 and 5.3% in 2023.

Higher inflation has driven increases in the Bank Base Rate, which is currently 1.25%. We expect further rate rises from the Bank of England, and are likely to end the year at 2.3%. Rate rises are expected to lead to a slowdown in economic growth during H2 2022.

The expected economic slowdown will heighten risks in commercial real estate markets with tighter lending conditions and a move towards yield expansion in some sectors. 

UK Annual Inflation, June 2022

Source: Office for National Statistics

Implications by Sector:

Logistics

Rising fuel costs and driver shortages have placed upward pressure on freight rates. While occupiers are increasingly seeking caps and collars for inflation, the market remains undersupplied and favorable for landlords. We expect occupier demand for industrial and logistics properties to remain strong, but the weakening economic outlook may begin to weigh on the sector. For the UK rising inflation, expected increases in interest rates and the cost of debt are putting pressure on yields.

Residential

Rising food and energy costs have placed a significant strain on household budgets. This, combined with recent house price rises and increased interest rates, will slow the momentum in the housing market. While we expect transaction levels to be lower in the second half of the year, overall they are likely to remain close to the long-term average.

In the Build-to-Rent sector it’s becoming evident that high inflation is being passed on to consumers, which is creating a backdrop for strong rental growth. HomeLet recorded annual rental growth of 11% in June. Despite this, strong demand is continuing to put pressure on yields across the sector. 

Office

Preliminary data for Q2 2022 shows an improvement in leasing activity, with large pre-lets accounting for a big proportion of the market, providing more evidence of the flight to quality. Prime rents in some markets have increased quarter-on-quarter due to continued high demand for the best quality stock in a relatively supply-constrained environment. Amongst other factors including labour shortages, business failure within the contracting sector is having an impact on the office development market. A large number of schemes are now subject to delays of 6-12 months. This is likely to further constrain the availability of new, high-quality stock. Looking ahead, high inflation and the likelihood of further increases in interest rates are likely to create a situation whereby the leasing market is more challenging for the next six months than it was in the first half of the year. 

Retail

Retail sales recovered following the pandemic-induced slump in early 2020, and remain above pre-pandemic levels as of May 2022. However, a pivot towards online shopping in key markets is partly attributable, with in-store sales still lagging pre-pandemic levels. Prime rents fell in the pandemic, but have since stabilised. However, with high inflation, many consumers are facing a reduction in their spending power and confidence is at a record low. Reassuringly, retail sales have remained relatively stable thus far, due to the healthy savings balances households built up during the pandemic. We expect convenience-focused retail to continue to outperform, as consumers focus on essentials as opposed to discretionary items. From an investment perspective, retail is less likely to be impacted by rising debt costs with yields comparatively higher than other sectors, and many investors already utilising cash for acquisitions.